#AskanExpert: What’s the best way to handle a student loan in default?

Q. I have a question regarding a student loan that has gone into default. I’ve reached out to the collection agency and have been given three options for paying off the loan.

1) I can pay off the loan in full immediately (including fees and interest). The result would be that on my credit report I would have a default remaining and the notation would read ‘paid in full in collection.’

2) I can pay a settlement (roughly 70 percent of the total cost) within 90 days. The result would be that my credit report still reads default with a notation that says, “paid in full in settlement.”

3) The third option is that I enter a rehabilitation program, make 9 monthly payments, the loan is given to a new creditor, and can then be paid off there. The result is that the default is removed, but late payments past 90 days still show up.

What do you recommend? Which is the best way to handle my student loan default?

Dear Reader,

If your credit score is already in bad shape, you should focus on the option that will allow you to rebuild your credit immediately. Looking at your three options, you should carefully review your first and second option, to pay in full or to settle. The main difference between these options is how the payment will be reflected on your credit report. It always looks more favorable on your report to show that you paid off your collections account in full rather than through a debt settlement. However, if you have a very low credit score, the negative impact of settling the account may not be that much different than paying it in full. How these actions affect your score depends on several factors. But, the lower your score, the less impact negative information will have on your report. So, paying the loan off may only give you a slight boost over settling the account. If you decide to move forward with a settlement, unless otherwise stated, you do not need to wait three months to pay it in full. Whenever you settle an account, make sure you get your agreement in writing before making your payments. Also, keep in mind that any forgiven debt over $600 can be considered taxable income, and you may have to pay taxes on it. So, keep that in mind when making your final decision.

One of the benefits of paying your student loan quickly is getting a boost in your credit score. After paying on time, your debt level or utilization ratio, is one of the most important factors influencing your credit score. Your utilization ratio is just how much debt you have compared to how much credit you have. So, the higher your debt, the lower your score. When you pay off your student loan in one lump sum, your overall debt will be reduced, decreasing your utilization ratio, and boosting your score.

Another benefit of repaying your debt through these two options is saving money. Your third option requires nine consecutive payments (which may include fees and interest rate) before you can pay it off or bring it out of default. An early pay off means you will have additional disposable income toward repaying other debts, saving or investing.

In addition to speaking to your banks, I also recommend you talk to an NFCC-certified credit counselor from a nonprofit agency. Your counselor can take an in-depth look at your credit report and help you explore in detail your options to deal with your creditor and rebuild your credit. Rebuilding your credit will require effort and time. And you’ll have to learn to use your credit strategically, making full, on-time payments and keeping all of your balances low. With discipline and the right guidance, you’ll be where you want to be in no time. Good luck.

Sincerely,

Bruce McClary, Vice President of Communications

Bruce McClary is the Vice President of Communications for the National Foundation for Credit Counseling® (NFCC®). Based in Washington, D.C., he provides marketing and media relations support for the NFCC and its member agencies serving all 50 states and Puerto Rico. Bruce is considered a subject matter expert and interfaces with the national media, serving as a primary representative for the organization. He has been a featured financial expert for the nation’s top news outlets, including USA Today, MSNBC, NBC News, The New York Times, the Wall Street Journal, CNN, MarketWatch, Fox Business, and hundreds of local media outlets from coast to coast.